If a company has debt, is it a bad thing?

If you’re looking for a company to invest in and come across one with debt, what should you do? Should you ignore this company as a potential investment? Or should you invest? Let’s take a closer look at companies and debt…

Debt can be advantageous to a company

In many circumstances, if companies didn’t take on some form of debt, they can’t pay for expansion, for instance. And debt can actually be advantageous to a company.

A company will borrow cash as it’s a cheap way of financing, Tim Bennett in Money Week explains. A company can put up an asset as security and in doing this can get a lower interest rate.

But when a company borrows money, there are consequences. For example, a company must pay its interest payments and any other debt costs before it can pay out any money to shareholders.

And if a company hits hard times and goes bust, it must clear its debts first before shareholders get anything back.

Lenders have the security of this knowledge when they lend money to a company. And this means it’s generally cheaper to borrow money from a bank than issue more shares and raise the cash from shareholders instead.

Gearing can benefit a company and its shareholders

But that’s not the only reason why companies borrow money. A company can benefit from the gearing effect of borrowing.

Let’s illustrate this with an example…

Take two companies. They both have net assets amounting to R100 million.

Company A is funded 100% by shareholder equity. In other words, the shareholders provided this R100 million.

Company B is funded 50% by equity and 50% by debt. The debt comes with a 10% interest rate on it. So shareholders provided R50 million and the remaining R50 million is from the bank.

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In a year, both companies make R50 million profit. That brings each companies’ net assets to R150 million.

If you sold both companies for the value of their balance sheets it’s a different story. Company A makes its shareholders a profit of 50%. But Company B makes its shareholders a profit of 100% as they only invested R50 million to start with.